• Angus Crennan

What are the risks and opportunities with interest rates near zero?

In 2020, drawing on lessons learned in the GFC, governments and central banks left nothing on the table responding to the coronavirus global pandemic. Alongside a host of other measures a key plank of response was to drop overnight interest rates to zero in the developed economies.


Everyone is familiar with the concept of moral hazard. It talks to behaviours which manifest when disciplines are absent. The first impact of virtually free money is increased demand for credit to undertake economic activity which otherwise would not be profitable. There are good and bad elements to this – firstly any economic activity can be welcomed as a capacity utilization during times of extreme stress, however using debt to undertake activity which at some stage needs to generate cashflows which not only can service but ultimately repay that debt is what is required. Central banks help here with forward guidance and suppressing the belly of the term structure (for example buying 3 year bonds across the bond market such that the yields on 3 year bonds reduce to a policymaker level determined level rather than a market determined level).


A second form of moral hazard is investor responses to interest rates near zero. Returns available to traditionally conservative investors who would ordinarily rely on investments in bank term deposits and investment grade bonds have decreased to the point that returns do not even compensate for inflation. These minimal returns prevent income generation, capital growth and legacy building which in turn forces capital out of asset classes like bonds, referred to in academic studies as ‘crowding out’, and into growth assets such as real estate and shares. Moving capital into growth assets is not only required for investors to generate returns and is justified via traditional valuations processes. For example investing in a dividend paying quality business valued using 5% discount rates is attractive when cash and bond yields are less than 1%.


Value of $100 to be received in 1 year at different discount rates

When you require 5%, then $100 in one year is worth $ 95.24,

" 3% .. is worth $ 97.09,

" 1% .. is worth $ 99.01, and

" 0.10% .. is worth $ 99.90.


2020 has seen the competitive landscape change enormously. Key is that there are excellent opportunities for nimble and well positioned businesses in this environment. The obvious candidates have increased to dangerous and unjustified valuations. Unearthing better opportunities is a worthwhile pursuit because the conditions for equities to generate attractive returns in 2021 are looking positive.


Merry Christmas everyone. Stay safe and have a wonderful New Year celebration.


Regards

Angus


Photo: Cherelle Martin. Sunrise at Balmoral.

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